401k Investing Decoded

Allow me to give you a hypothetical situation. Say I offered you free money no questions asked, do you think you would turn it down? In fact a lot of people these days, especially young people, are doing just that. By not taking advantage of a 401k plan many Americans are simply throwing away free money and it makes me absolutely crazy.

I got the opportunity to write a research paper about retirement this last semester in school and in my research I uncovered a startling statistic: two thirds of U.S. workers surveyed said they or their spouse had saved for retirement (Preparing for Retirement in America). That means one third of workers surveyed have not saved and that is staggering. Everyone who has access to a 401k should be taking advantage of it. This is a simple guide to get you started.

Basic Info

A 401k is a type of retirement account associated with a job. You need to start by finding out if your company offers 401k benefits. If you don’t work full time or you work for a small company there is a fair to good chance you won’t have access to a 401k. In this case you need to look into a Roth IRA (please stand by for future post). A 401k has advantages over simply putting your money in the stock market. Those advantages come in the form of tax benefits and possible free money offered by your employer. In my opinion it’s sad that more Americans aren’t informed about retirement options.

According to recent estimates from the Bureau of Labor and Statistics, 80 percent of U.S. full time workers have access to a 401k through their employer. However, since the economic downturn participation in plans has been lacking.

Free Money

The main advantage of the 401k is that often times your company will match a portion of the money you put in. For example, if you put in 6% of your annual wages the company may agree to match 3%. That three percent the company puts in is literally free money. They are giving it to you as an advantage of the retirement plan. My advice to my readers would be to take advantage of the match but no more. If your company matches up to 5% put in 5%. If they only offer a 3% match put in 3. I have to emphasize that all companies have a different formula for this matching business so it’s important to be frank with your HR person and get all the info.

Tax Benefits

When you decide to put money aside in a 401k the money is not taxed. ┬áThe money will be taken directly out of your paycheck before you even get paid. I think this is actually a contributing factor to why people choose not to use their 401k. They don’t want their paycheck to be smaller. Unlike money put in the stock market, you won’t pay taxes on capital gains or interest yearly. Instead, you’ll just owe income tax on the money when you use it (after the age of 59 1/2).

What the Heck to Invest in

This is often the most stressful and confusing part of having a 401k. When I got my first big girl job in 2013 I had no idea what fund I should put my money in. I kind of just chose something randomly which is what a lot of people end up doing. Luckily for me it worked out but theres definitely a better strategy than taking a stab in the dark.

Most 401ks will offer a target date fund. Generally the fund will choose a date of retirement which is probably listed in the name of the fund. Target funds start out with high risk, high return investments and over time shift to lower risk investments like bonds. If I invest in “Target Retirement 2045” my money will most likely be invested in almost all stocks. I can afford to have larger losses because I’m young. As I get older losses will affect me more and the fund manager will make the risks lower as my deposits grow. I recommend these types of funds for people who don’t know much about investing because they’re easy…you can’t go wrong. The downside to these types of funds is they come with higher expense ratios because they are more actively managed. In investing you want to watch your expense ratio. At the moment the fees for Target date funds are running around .75% which isn’t terrible but you can do a lot better as far as fees go.

Another option you have are mutual funds. A mutual fund is just a group of stocks and bonds. Mutual funds give you greater options and diversification for what to invest in. You may have a choice between 15 to 20 different mutual funds and you may divide your money between several different ones within the 401k. The idea behind a mutual fund is it has a manager and that manager is attempting to outpace the market. They look for inefficiencies and places to invest that will earn their investors money ahead of what the stock market is doing as a whole. This is why mutual funds also carry high fees. The mutual fund manager says “put your money in my mutual fund and you may pay more fees but I am very smart and I will make you more money than just investing in regular stocks on their own.”

The final type of fund I’ll discuss is the index fund. Index funds are the most simple and boring. They are made up of stocks and/or bonds just like mutual funds but they are not actively managed. They are designed to draw from the stock market and match exactly what it does. For example, Vanguard’s 500 Index Fund (VFINX) is designed to trace the S&P 500 which is a group of the 500 largest companies on the stock market. Index funds have the lowest fees. The expense ratio for VFINX is .17% at the moment. The downside of an index fund is you have less guidance as to what to invest in. You’ll have to do your own research to know which to pick. In my experience 401ks don’t offer many index fund options. The 401k at my current job offers exactly one option among 20 other funds. Guess where all my money is.

My Thoughts

My personal opinion is index funds are the best option. Mutual funds are expensive and the fees you pay are supposed to go towards outpacing the market. The truth is most mutual funds don’t do better than the market as a whole and your deposits are more likely to get eaten up by fees. With the index fund you are tracing the market. If the market does well the index fund will do well. You may be able to choose an index fund that traces a certain sector such as healthcare or energy which provides more diversity than just putting all your money in one particular fund. If you really don’t know what to pick go with the target date fund. These funds may carry some high fees but you also won’t get yourself into trouble with extremely risky investments. Also, be sure you’re choosing the target date fund that most closely matches the date you’ll retire.

As always when you put your money in the stock market you could lose it. All of these funds are based in the stock market and any one of these types could lose your money if the market goes bad. There is no way to save for retirement that is completely stable. If a money manager ever tells you your deposits are protected from market volatility I want you to take your money and run.

The other night I had the opportunity to see the movie The Big Short. The movie talks about the financial crisis of 2008 and about all the people who lost their jobs, homes, and almost all of their retirement savings. People have made the point to me that I may be in a good retirement position now but since all the money is in the stock market it will go away when we have a financial crisis again. That may be true but I’d like to point out that the alternative is either 1) not saving for retirement at all or 2) putting money away in a savings account earning 1%. Those options are not options. If a savings account is your retirement strategy you’ll be quite short on funds when retirement comes.

I always try to remind people that they can be smart about their money. Stock market investing is scary. 401k sounds like such a grown up word. If you start out making one good decision you can build on it. I implore you to take advantage of a 401k if you have access to one. Investing in something is a lot better than doing nothing especially because a 401k is offering you free money. Start now, whatever age you are, and next year you’ll be so glad you started.

 

 

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